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Saturday 21 August 2010

Forever Blowing Bubbles

I've been promising a weekend post for a while setting out my thoughts on how the new few years might play out on the markets, and this seems a good weekend to do it, as EURUSD broke key support with conviction on Friday, and my bear scenario is back to being my primary scenario as a result, somewhat aided by important support breaks as well in ES, GBPUSD and Oil over the last few days.

My bear scenario has a downside target of 870 and I laid it out in the post below on 21st May:


Just as an aside, I see that I posted a rectangle target for 30 year treasuries at 134 in that post, and we reached it this week.
Looking at the world around us it is hard to imagine the economic policies that are being followed round the world nowadays ending well, and I have read a lot of economic history which suggests that they will end badly.

Furthermore, from my reading of secular bear cycles in the past it looks clear that the current secular bear cycle is likely to last several years more before bottoming out, and that we have at least one more harsh cyclical bear market to come before the end of that cycle.

None of that means however that equities will make new lows soon, and the key lesson of the last eighteen months is that if governments are prepared to throw all fiscal caution to the wind, and print and borrow staggering sums to counterfeit the appearance of genuine prosperity, then it can be counterfeited for a while, and if it can be counterfeited for eighteen months, then potentially it can be counterfeited for a while longer than that. Alan Greenspan's comments at the beginning of August were a revealing insight into the thinking of the clever fools at the Fed who let the asset bubbles of recent years inflate, and are now doing their very best to 'save' the economy by reinflating them.

Alan Greenspan speaking to Meet The Press on 1st August 2010

'I wish I could answer that one. It’s a critical issue because, as you point out and as I’ve always believed, we underestimate the impact of stock prices on economic activity. Asset prices are having a profoundly important effect. What created the extent of the contraction globally was the loss of $37 trillion in market value. It collapsed the value of collateral in the system and it disabled finance. We’ve come all the way back–maybe a little more than halfway, and it’s had a very positive effect. I don’t know where the stock market is going, but I will say this, that if it continues higher, this will do more to stimulate the economy than anything we’ve been talking about today or anything anybody else was talking about.'

From: http://seekingalpha.com/article/218017-greenspan-new-stock-market-bubble-needed

My belief is that we are in the last of a series of bubbles, with this current bubble being a government debt bubble, and that this bubble will end in a bond crisis centered on US treasuries that will raise interest rates, enforce austerity, and cripple both the US (and other) governments' ability to borrow irresponsibly, and as importantly to print money to boost the economy and finance their deficits. Minor issues like Greece notwithstanding, I don't see any sign at all of that crisis in the near future.

We are therefore currently in a mainly technical market, where longer term economic fundamentals mean little in assessing short term valuations, and while that is the case then we may go up further before gravity catches up with us. Meanwhile we're living through a very strange period in economic terms.

My theory, which I'm hoping to make the central theme of a book on this secular bear that I'm thinking of writing after it has all played out, is that we are in a three stage debt bubble as follows:

The start of the series of bubbles, loosely speaking, was in 1995 when the SPX broke the long term rising resistance trendline dating back to 1937 that had been hit previously at the major highs in 1966 and 1987, and that SPX had bumped along just underneath in 1993 - 1995. It was in 1996 of course that Greenspan famously referred to 'irrational exuberance' in the stock markets, and no doubt he was referring to this initial break above the long term trend. Just as famously he then did nothing to stop that bubble inflating, and we have been riding the waves ever since.

That first bubble was the corporate debt bubble, culminating in the peak in 2000. As that bubble deflated, central banks responded with low interest rates and a flood of liquidity and inflated the second bubble in the series.

The second bubble, 2003 - 2007 was the personal debt bubble. After the peak in October 2007, and the brutal bear market that followed, central banks responded once again with low interest rates and a flood of liquidity.

The third and final bubble, starting 2009 and end date to be advised in due course, is the government debt bubble.
  1. 1995 - 2000 Corporate debt bubble
  2. 2003 - 2007 Personal debt bubble
  3. 2009 - 2012 (?) Government debt bubble
    To put this into the longer term historical context I have borrowed and annotated a chart from Atilla to show the long term SPX rising channel and to illustrate how far we moved away from the longer term trend during the first bubble particularly. You'll note that is is a rising channel going back to the 30s with a short break below in WWII and the major break above from 1995.

    I don't see us making a final low until after the end of the final bubble and we're just not there yet. This last bubble is necessarily the last bubble in the series as after it ends there will be no-one left able to inflate another. I'm expecting a US sovereign debt crisis and bond market revolt in a year or two that forces austerity, ends the last bubble, and starts the final cyclical bear market of this secular bear cycle. After that bond market crisis, then governments will no longer have the option of lowering interest rates or of releasing a flood of liquidity into the economy, and that final cyclical bear market will therefore take place without any major keynesian interventions.

    What matters to us though is what will happen in the interim, and I have a theory for that as well.

    As I said in my post on 21st May, I'm expecting a low on the bear scenario this year in the 870 area, as that is the target area for both the broadening formation and the big head and the shoulders pattern on SPX, as well as being the key support / resistance level in the October 2008 to July 2009 period. There is another pattern that I should point out too (thanks to BloodWine for bringing it to my attention), and that is the possible bearish gartley pattern that may be developing after the April peak on SPX hit an almost perfect 61.8% fibonacci retracement of the fall between October 2007 and March 2009. A perfect 61.8% retracement would have hit 1228 and SPX hit 1220 which was very close. A bearish gartley pattern retracement of the rise into April 2010 would target a (61.8% to 78.6%) range between 878 to 785 SPX and that would give us the first three legs of the pattern. If we hit 878 exactly, then the fourth leg would target a range between 1312 and 1431, and if we hit 785 exactly then the fourth leg would target a range between 1337 and 1488. The completed pattern would then look like this:

    You can see a classic example of this kind of pattern here at investopedia.

    Does that sound too incredible? Perhaps, but it seems generally accepted that if the stock market goes below 900 then the US government will respond with a massive new round of stimulus and printing money, and Greenspan's comments show the thinking behind that. That worked last time, for a while, and I think that it may well work again, for a while.  Equally it seems clear that the Fed will persist with this strategy until it can no longer do so, which brings us back to that bond market crisis I'm expecting.

    I'm no expert with EW but that would also complete an ABC correction from the March 2009 low, and to my eye, the wave up from March 2009 was a five wave sequence, with the third wave ending in January 2010. Though I know that is debatable, one five wave impulsive wave sequence strongly implies at least one more impulsive wave up, according to EW rules.

    So what else do I have to suggest that after a steep fall over the next few months, we would then have a steep recovery? Well, there is the first chart of course, where the scenario I am describing would complete a retest of the rebroken upper trendline of the rising channel, and then there's this 50 year chart of the SPX adjusted for CPI that I came across a few months ago. I've added the arrows to show the perfect steep real terms reversion to mean declining channel over the course of the secular bear market since 2000, and once again the completion target for the bearish gartley pattern would take us into the right area to hit the upper trendline of this real terms SPX declining channel:

    So there it is, a logical theory backed up with some nice charts. Will it happen? Only time will tell. :-)

    I'll leave you with a couple of final thoughts. The first is that in recent days we have seen at least one, and possibly as many as three Hindenburg Omens. Now these may or may not be greatly significant in terms of an imminent fall, and as much as anything else I think that these omens are alerting us to something many may have missed, which is that the market has barely moved in the last year. It will be the 23rd of August on Monday, and on Monday 24th August last year the SPX HOD was 1035.82. SPX closed just 36 points higher than that on Friday.

    Why's that significant? Because the omen requires that a significant number of new 52 week highs and lows must be made for an omen to trigger, and for that reason I remarked to someone a year ago that we couldn't realistically see one for quite a while because of the huge range over the previous 52 weeks. The range now over the last 52 weeks is some 200 points, rather than the 700 or so points a year ago, so the range is now narrow enough for Hindenburg Omens to trigger.  To that extent the omens are just reminding us that the range over the last 52 weeks is narrow, and that we have come significantly off the top.

    The second is a very thought-provoking recent chart from Goldman Sachs reposted by Clusterstock Chart of the Day last week. It is the GS analysis of the impact of fiscal stimulus on US GDP growth from the beginning of 2009 to the end of 2011. This doesn't tell us that we could necessarily make the upside target on the gartley pattern with a massive new stimulus, but it does suggest that without that stimulus, earnings forecasts over the next year look wildly overoptimistic. You can see the full CCOTD write-up here:

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